Global capital securities – an income alternative/complement to local hybrids

The global banking universe has improved its fundamentals through higher capital ratios and balance sheet de-risking since the global financial crisis much like Australian banks have done.

To date, most global capital securities are only accessible to institutional investors. With its larger market size and variety relative to ASX bank hybrids, they offer ample opportunities for active management through the investment cycle.

What are capital securities?

In Australia, capital securities are often called "bank hybrids" because they tend to have both equity-like and debt-like characteristics. In the capital structure (figure 2 below), these securities sit above equities but below senior debt in the event of insolvency. They also offer a higher level of return above unsecured creditors to compensate for this risk. As an asset class, they tend to offer some of the highest yields of all liquid investment grade rated bonds or near-investment grade rated bonds.

During financial stress of the COVID-19 crisis, some banks had their dividends stopped or reduced. However, capital securities were not affected in that period because their issuance terms requires a much higher loss threshold before payments are stopped.

Improvements since the GFC

Since the 2008 financial crisis, banking sector reforms, based on the major rewrite of global banking standards by the Basel committee on Banking Supervision, has:

• driven material increases in the core capital of banks, 
• reduced on-balance sheet risk-taking, and
• forced banks to improve liquidity and funding stability. 

As a result, banks are required to hold more capital against their assets, in particular against riskier forms of lending (capital charges for banks are based on the level of credit risk). In line with this, banks have revised their risk assessment and lending practices and, in many cases no longer lend to parts of the market with high levels of credit risk.

Subsequently, since 2009 non-performing loans have reduced in the sector, especially in Europe where the periphery has actively provisioned and sold bad loans.

Financial regulators around the world are more conservative than they were and now require banks to have higher capital funding for their balance sheets. As a result, there has been a large amount of issuance of Capital Securities, which has expanded the investment opportunity set. Despite banks now having better capital ratios, the credit spread for these securities is still wider than pre-2008 securities. Remember the credit spread is the difference between the yield of risk-free bonds, such as US Treasuries and another debt security of the same maturity but with a different credit quality. A tight credit spread can indicate good economic conditions, high liquidity or high demand for sought after bonds, so the current spreads may be an opportunity as they are wide considering the capital ratios.

Figure 1: Spreads are wider than 2009 despite better fundamentals

_{Source: Bentham, Bloomberg, as at 30 July 2021}

Two of the more common types of securities are Additional Tier 1 (AT1) and Tier 2 Securities. These securities sit above equity but below senior unsecured debt (as shown in the table below).

Figure 2: Bank’s capital structure

_{#Per ASIC Report 365. *Per market convention.}

Under the original Basel III reforms released in 2010, a bank's AT1 and Tier 2 assets were envisaged to be 1.5% and 2% of its risk-weighted assets, to meet the 6% Tier 1 capital and 8% total capital requirements. Since then, national regulators have taken varying approaches to total capital requirements, generally requiring banks to hold further buffers and allowing more AT1 and Tier 2, which has led to incremental capital security issuance. These securities included key new terms and conditions in regards to loss absorption and coupon cancellation. However, given the fundamental improvements, the primary area of risk focus is on extension risk, being that, the bonds are not called and left outstanding. Because of these terms being included, AT1 securities can also be referred to as ‘contingent convertible securities’ or CoCo’s.

Current Spreads on Offer

Because of the structural improvement in the banks’ balance sheets, the current spreads on offer in this space offshore are attractive relative to liquid investment grade and high yield credit at present. Importantly, COVID-19 showed that bank dividends could be reduced while hybrid coupons remained fully paid.

As an example, the Yield to Call¹on an average European Capital Securities portfolio is currently around 3.3%, almost 1.0% above that of the local hybrids market (including franking).

Looking at figure 3 below, ASX hybrids are shown by the light green dots versus the European and UK bank CoCo universe. You can see Bank of Ireland, Lloyds and Societe General are trading at wider spreads than ASX hybrids.

Figure 3: Spreads and Years to next call – ASX listed hybrids vs offshore capital securities

_{Source: Bentham, Bloomberg, as at 30 July 2021}

Market size differential: ASX hybrids versus offshore

The global capital securities market is at least 24 times larger than the Australian hybrid market. Australian major banks account for roughly 77% of all domestic ASX listed hybrid issuance, spread across only 4 issuers and 22 securities. This is dwarfed by the opportunity set offshore.

Figure 4: Bigger universe equals greater opportunities: Global Capital Securities Market

_{*Select currencies USD, GBP, CAD, EUR, AUD.
Source: ASX, Bloomberg, Bentham, 30 July 2021}

If something were to go wrong with the Australian economy and an Australian major bank, not only would it severely affect the equity valuations of the banks, but also the valuations of these types of securities as well.

Liquidity size differential: ASX hybrids versus offshore

The ASX listed hybrid market tends to attract domestic and retail investors because franking credits are a key driver of valuations and not valued by offshore investors. This limited buyer base means that the market pricing and liquidity is sensitive to local demand. Hybrids are tightly held by buy and hold investors. By contrast, the European and UK bank “CoCo” market is a globally traded institutional market with higher levels of turnover. This also creates the opportunity for active management.

Figure 5: Trading levels of ASX listed hybrids vs offshore capital securities

_{Volume Traded / Amount Outstanding
Source: Trax, Bentham, Bloomberg}

Further, by having overlapping exposures to Australian banks via both shares and hybrids (for income) many investors’ portfolios exhibit unnecessary concentration risk that can be mitigated by investing globally.

Active management is key

Given the complexity around structure, triggers, optionality and hedging the risk it is necessary to take an active approach to identify mispricing opportunities.

VanEck together with leading credit & fixed interest specialists Bentham Asset Management have created a global capital securities opportunity on ASX, the VanEck Bentham Global Capital Securities Active ETF (Managed Fund) (ASX: GCAP).

In a world where income remains a key issue for retirees, bank capital securities are well placed to meet this demand.

By expanding the capital security universe to include selected offshore markets, which are not accessible to retail investors, investors can benefit from not only a larger opportunity set but also additional diversification.